Coal India IPO Analysis

A controlled giant

Being a government company, volume growth will be constrained and price growth uncertain. Yet it has the potential to attract many institutional investors

Coal India, a navratna public sector undertaking under the Ministry of Coal, Government of India, is the largest raw coal producing company as well as largest coal reserve holder in the world.



CIL, incorporated on June 14, 1973 as Coal Mines Authority, following nationalization of coal mines, carries its coal production operations through its seven subsidiaries (wholly owned). Another wholly owned subsidiary Central Mine Planning & Design Institute (CMPDIL) is engaged in offering technical and consultancy service for the operation of the CIL as well as third party clients for coal exploration, mining, processing and related activities. The company has also established Coal India Africana (CIAL) to pursue coal-mining opportunities in Mozambique, an East African nation. Currently, CIAL has obtained prospecting license for development of two coal blocks in Mozambique.

CIL operated 471 mines in 21 major coalfields across eight states in India as of March 31, 2010 producing non-coking coal and coking coal of various grades for diverse applications. While non-coking coal is used in thermal power plants and the cement industry, coking coal is largely used in metallurgical industry. In FY 2010, about 91.6% of the total coal produced was of non-coking coal and the balance was coking coal.

According to the audited reserve and resource estimates carried out by SRK Consulting (UK) and its Indian arm and classified in accordance with the JORC Code, the company had about 18862.9 million tons of total reserves and 64218 million tons of total resources. Of the total resources, the measured resources, indicated resources and inferred resources will respectively be about 51326.3 million tons, 9924.4 million tons and 2,967.3 million tons. Of the total reserves, about 10595.1 million tons are proved reserves and 8267.8 million tons probable reserves. Proved reserves and probable reserves are economically mineable part of measured mineral resources and indicated mineral reserves, respectively. Probable reserve will also include economically mineable part of measured mineral resources.

Majority of the coal sales of the company is under the long-term fuel supply agreements (FSAs). In addition, the company also sells raw coal through the e-auction scheme, which was introduced in accordance with the New Coal Distribution Policy issued in 2007 with a view to provide access to coal for such buyers who are not able to source through the available institutional mechanism. CIL can sell around 10% of its production through e-auction at market-determined prices. Allotment of coal by e-auction is reviewed periodically by the ministry of coal. CIL also sells high-grade non-coking coals under the Memorandum of Understanding, negotiated with Customers.

Under the FSA mechanism, CIL issues letter of assurance (LoA) as recommended by the Inter-ministerial Standing Linkage Committee for supply of coal and convert LoAs issued into legally enforceable FSA subsequently after meeting certain project milestone criteria by the customer.

Following the so-called deregulation of coal prices in January 2000, the company is permitted to determine the price of its coal and coal products. The price of non-coking coal and coking coal to be supplied pursuant to FSAs is fixed by the company in consultation with GoI and notified from time to time. However, the reserve price of raw coal sold pursuant to e-auction scheme is determined on the basis of prevailing market prices. Similarly for the high quality coal sold under MoUs negotiated with customer, the price for that is fixed at a price that is generally 15% discount to the prevailing landed cost of comparative quality imported coal and is typically significantly higher than the notified price of non-coking coal of the same grade sold under FSAs.

To meet the growing demand for coal in the country, the company continues to increase its coal production. Currently the company has investment approval from its board as well as that of its respective subsidiaries for implementation of 77 projects with an aggregate additional capacity (proposed) of 184.78 million tons per annum involving an aggregate capital expenditure of Rs 11006.46 crore.

Of these 77 projects for which requisite investment approval had been received, 32 projects with an aggregate capacity of 104.00 million tons per annum had been implemented by March 31, 2010, and have contributed about 57.0 million tons towards the production during fiscal 2010 itself. Of the balance, about 25 projects with an aggregate estimated capacity of 47.51 million tons per annum were at various stages of implementation as end of March 31, 2010 and are expected to become operational by end of FY2012. These 25 projects are estimated to involve an aggregate capex of Rs 3385.71 crore. Further another 20 projects, with an aggregate estimated capacity of 33.27 million tons per annum are expected to become operational during the 12th Five-Year Plan (2013-2018) period. These 20 projects are estimated to involve an aggregate capex of Rs 2576.28 crore.

Currently the company has 17 coal benefication/ coal washeries, with an installed capacity of 39.50 million tons per annum (mtpa) and it has embarked on setting up another 20 coal washeries, with a capacity of 111.1 mtpa apart from efforts to increase capacity utilization of some of the existing coal washeries, which are bogged down by lower capacity utilization on account of older technology. In addition the company proposes to put up a dedicated benefication facility for all new open cast mines, which are of a rated mining capacity greater than 2.5 million tons per annum.

Apart from 11 direct and indirect subsidiaries the company have incorporated a 50:50 JV company named CIL NTPC Urja primarily to jointly undertake development, operation and maintenance of certain coal mine blocks in Jharkahand and integrated coal based power plants. The company has also established a JV company i.e. ICVL with SAIL, NTPC, NMDC and RINL for acquisition of coal assets outside India. While CIL and SAIL have 28.7% stake in ICVL the other partners have 14.3% stake each.

Strengths

CIL is largest coal producer in the country as well as in the world with its production for FY 2010 at about 431.26 million tons, which represents 82% of India's coal production. Further the company is also the largest coal reserve holder in the world as of April 1, 2010, with about 18862.9 million tons of total reserves and 64218 million tons of total resources. India is the world's third largest producer and consumer of coal given strong growth in economy. The demand for coal in the country is expected to grow to 713 million tons per annum in 2011-12 compared to 600 million tons per annum in FY 2009-10 on the back strong demand from sectors such as power and other energy intensive industries such as steel and cement. However the country's coal production is expected to grow to 630 million tons by 2011-12, thus leaving a shortage of about 83 million tons. Thus, if there is any limitation for growth it is the inability of the company to pace its production inline with the demand growth for coal in the country.

On going mine expansion projects as well as improvement in productivity of certain existing mines, will drive volume growth going forward. As per the MoU signed by CIL with the Ministry of Coal, the targeted coal production is 461.5 million tons (up 7% y-o-y) and 462.5 million tons of off-take in FY 2010-11. Further, the production is targeted to increase to 486.5 million tons in FY 2012. Out of the 21 coal-fields of the company, barring the four (Korba, Singrauli, Talcher and IB Vallery), the productivity/ capacity utilization of others are very low (below 50%). With the company making efforts to improve the productivity with investment in modern mining equipments as well as bringing back the abandoned mines for development may facilitate scale up in production from existing mines itself auguring well for the company.

The difference between average realisation for raw coal and that of beneficated coal is significant at around Rs 1000 per ton with average realisation for raw coal in FY 2010 being Rs 1045 per tonne and that of beneficated coal being Rs 2134 per tonne. With the per ton cost of benefication (after considering 20% wastage of raw coal in washing process) being Rs 200 per ton, there is large room for higher profitability provided there is shift in product mix. Currently just about 3.4% of the total coal produced by the company is beneficated/ washed with balance being raw coal sold either through FSA or e-auction. While the pithead customer normally prefers raw coal off-take the customers from far off locations prefer beneficated coal due to logistic gains/advantages as well as quality of the coal. Currently the company though has a coal benefication capacity of 39.50 million tons per annum (mtpa) it is handicapped by lower capacity utilization on account of outdated technology. The company is currently investing on up-gradation and modernization of its existing capacity apart from investing in 20 new coal washeries with an aggregate capacity of 111.1 mtpa. Though the new capacity of 111.1 mtpa will be available gradually during 2013-2018, the company can significantly ramp up benefication of coal with modernization as well as taking the service of third party coal washeries, which have an aggregate capacity of 130 mtpa in the country currently and largely close to CIL coalfields. In-house, the company can capture value from the wastages but that is difficult in case of outsourcing. Similarly the average realization of sale of raw coal through e-auction being significantly higher (Rs 1582.8 per tonne in FY 2010) compared to normal sale of raw coal under FSA any upward revision in current e-auction cap of 10% of raw coal production to 20% gradually as recommended by Planning Commission will result in spurt in realization as well as profit in the medium-to-long term.

The average coal mining cost stands at Rs 745 per ton in FY 2010 with the cost of mining for open cast mines it's about Rs 520 per ton and that of under ground mine being Rs 2795.41 per ton. About 85-90% of the coal production of the company in the last five fiscals is coming from open cast mines even though the company has about 273 underground mines, 35 mixed mines over and above the 163 open cast mines. Lower cost of open cast mining largely stems from the lower weighted average strip ratio of 1.9 for 17 major open cast mines of the company, which account for 49% of the FY 2010 production. Higher production from open cast mining and improving productivity helps to keep the mining cost lower thereby providing strong competitiveness. While the production capacity of the company is expanding the employee base of the company, which was at 439343 as end of FY2007, has dropped to 394041 as end of June 30, 2010. This was achieved by redeployment of workforce from less productive units to high productive and newer units and retirement/natural attrition. This with investment in higher capacity new technology mining machines has improved the productivity and this is likely to keep the production cost lower going forward.

Favorable geographic and geological conditions of the company's coalfields including a low stripping ratio (0.7 min to 5.2 max), enables to bring into operation large open cast mines within short time frames with low investment

Weaknesses

As the price of coal has significant ramifications on the Indian economy in general and the thermal power sector in particular, the price of FSA coal has been notified by the company in consultation with Government of India even though it has price determination power under so called decontrol of coal price in 2000. The company has increased its prices just four times since the decontrol of pricing in 2000. Most of the price rise has been to pass on the increase in cost of production and not related to open market prices. Hence delay in case of passing of any rise in cost of production that has to be absorbed by the company in the interim. Moreover, CIL's power regarding distribution is limited as coal allocation among customers is administered by GOI under the New Coal Distribution Policy, which largely nullifies the pricing autonomy.

The Mines and Minerals (Regulation and Development and Regulation) Bill, 2010, which was proposed to be introduced in the CY 2010 winter session of the parliament requires mining companies including CIL to share 26% of its profit with local inhabitants and would base the award of mining blocks in the future on an auction basis. While the company is confident of passing on the profit sharing cost to the customers given the sensitiveness of coal price in the economy of the country its ability to pass on the same remains to be seen.

Currently the expenditure incurred for removal of excess/less quantity of overburden (than the ratio fixed in project report) for production of coal in a particular year is adjusted against the profit and loss account by creating/utilizing reserves in the financial account. This is done to maintain uniformity of expenditure for production of coal by removing overburden throughout the life of the project. However, International Financial Reporting Standards (IFRS) require to charge this amount in the same year and in that case it may have significant impact on the profit and loss account of the company including tax implications. As of 31 March 2010, the company had maintained overburden (OBR) adjustment account of Rs 12447.39 crore and OC P/L and Reclamation of Rs 426.705 crore. On the positive side, implementation of IFRS may mean writeback of sizeable portion of the provisions already made.

Four coal fields of Korba, Singrauli, Talcher and IB Valley accounted for about 56-58% of the total coal production of company in the last three fiscals and any disruption either natural or manmade in production of any of these coalfields will severely affect the overall performance of the company.

Coal dispatches of the company were largely on railways (47% in FY 2010), roadways (30%)and dedicated rail MGR Systems owned and operated by the customers. The balance is ‘others' including desptaches to pithead customers via ropeways. Any infrastructure bottleneck such as non-availability of inadequate wagons will affect the dispatches. Normally CIL's sales are either ‘free on rail' or "free on road' from designated dispatch points and transportation is arranged by customers at their costs. CIL bears the cost of transportation from mine to designated dispatch point if the distance between the mine and dispatch point is less than 3 km and between 3.1-20 KM the customer has to bear at notified rate. Over and above 20 km the customer has to bear the actual cost. Hence any rise in cost of transportation might have also significant bearing.

The company has entered into letter of assurances (LOAs) for the sale of coal that exceed its expected production. If it were to enter into FSAs with respect to all such LOAs, the shortfall in supply of coal from its production is estimated to be about 110 million tons in FY2011 and about 235 million tons in FY2012. Normally, under FSAs, the company is not liable for compensation / penalty etc., if it meets 90% of the agreed volume in case of the power sector and about 60% for non power sector. The company has to meet these triggers either from its domestic production or imports. Moreover, the company can't divert the 10% e-auction quota to meet these obligations.

Indian coal, including Coal India's, suffer from high ash content, and hence it will have to be offered at a significant discount to the landed cost of imported coal.

Given the number of approvals required for mining project and given the fact of coal reserves largely being in declared forest areas, the projects might got delayed affecting the growth of the company. This is major concern due to recent surge in Maoist movements.

Valuation

Consolidated sales of the company for the fiscal ended March 2010 was higher by 14% to Rs 46689.29 crore and the net profit was up by 142% to Rs 9833.70 crore, albeit on a lower base. The EPS for the fiscal was Rs 15.2. The offer price band of Rs 225-245 discounts the FY2010 consolidated earning by 14.8-16.1 times, which is largely in line with the P/Es at which other global coal majors (especially Asian) are trading. However, while other global majors' earnings are more sensitive to fluctuations and cyclicality in coal prices, Coal India's earnings are largely immune to global coal price fluctuations as Indian coal prices as directly/indirectly determined/influenced by government and are much lower than international prices and their trend does not bear any relationship with global coal prices. In that sense Coal India may be treated as utility company rather than a commodity company. Other such Indian utilities like NTPC, Power Grid Corporation and Gail trades around FY 2010 P/E of 20.

It is expected that there will be strong post-listing interest in the scrip even at higher P/E multiple due to strong institutional (especially FII) demand as it is the only Indian stock which gives exposure to the Indian coal industry and the scrip's likely inclusion in leading Indian and global indices. Thus scarcity premium and index company premium can spice up the scrip post listing.